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Statement for US-China Commission Hearing, May 19, 2005

Offshore outsourcing is
misunderstood by economists and policymakers. The
phenomenon is misperceived as an extension of the mutual
benefits of comparative advantage-based trade.

Comparative advantage has two
necessary conditions, neither of which is met today. One
condition is that capital is immobile internationally
relative to
traded goods. The other is that the trading
countries have different opportunity costs of producing
the traded goods. (The economic concept of
opportunity cost is an in-kind measure; for example,
the quantity of
wine that is not produced in order to make a yard of
cloth.)

The condition of capital immobility
is required to insure that a country`s capital seeks
comparative advantage at home instead of absolute
advantage abroad. Different internal cost ratios of
producing one good in terms of another are necessary if
low- and high-cost countries are to experience mutual
gains from specializing and trading.

David Ricardo discovered
comparative advantage when he investigated the question
of why a country that could most cheaply produce all
tradable goods would trade with a higher cost country.

Ricardo`s answer is that the
opportunity cost of producing one good in terms of the
other was different in the two countries. He was able to
show that total output would increase if each country
specialized in the product in which it had relative
advantage. He then showed that the increased output
would be shared by the terms on which the countries
would trade one product for the other.

In Ricardo`s example, the different
opportunity cost ratios of producing wine and cloth in
the two countries are due to inherent differences in
geography, climate and soil.

Modern production functions,
however, are based on acquired knowledge. They operate
the same in all countries. These production functions do
not reflect country-specific inherent differences that
result in different opportunity cost ratios on which
comparative advantage depends.

When I point out that the
conditions on which the case for free trade is based are
no longer met in today`s world, economists either evade
the issue or drag red herrings across the path. They
talk about shifts in the terms of trade, about
productivity gains abroad, and about the pervasiveness
of factor mobility even in Ricardo`s time. They equate
the rise of the high speed Internet and collapse of
world socialism, which made
vast quantities of cheap labor available to first
world capital, with
innovations such as lower transport costs that
turned previously non-traded goods into traded goods.

None of these arguments engages the
issue. Ricardo imposed the condition of relative
capital immobility internationally in order that
specialization according to comparative advantage could
occur. Otherwise, a country`s capital would flow to
absolute advantage abroad. When US firms substitute
foreign labor for domestic labor in their production
for domestic markets, capital is flowing to absolute
advantage.

Factor mobility from Ricardo`s time
to the recent advent of offshore outsourcing was
qualitatively different. Foreign investment was a way to
evade tariffs, quotas, and high transport costs. Foreign
investment was not geared toward offshore production for
home markets.
Ford and GM produced cars in Europe to sell to
Europeans, not to export to America.

Economists assume that offshore
production for home markets is trade because the goods
count as imports when they enter the US. But what is
being traded when a US firm closes its American factory,
lays off its American work force, moves its capital and
technology offshore and uses foreign labor to produce
the identical product for the same US markets? This is
not trade in the traditional sense with one country
specializing in cloth, the other in wine, and sharing
the gains.

The old free trade argument that US
labor has nothing to fear from cheap foreign labor,
because US labor works with more capital and better
technology no longer holds when US firms provide the
same capital and technology to foreign labor. The
international mobility of capital and technology and the
advent of production functions that operate the same
regardless of location mean first world labor will be
displaced in tradable goods and services until there is
a global equalization of wages and living standards.

Indeed, one reason the facts of
offshore outsourcing are evaded by so many economists is
that they look with favor on the international
redistribution of income and wealth that is occurring.

As the BLS payroll jobs statistics
make clear, the US has
ceased to create jobs in tradable goods and services.
The higher productivity, higher value-added jobs that
provide upward mobility are missing from the data. Our
most prestigious engineering schools report a marked
decline in enrollments in computer and electrical
engineering. Business Week magazine reports that US
firms are now outsourcing R&D, design and innovation.

As I report each month following
the BLS release, so far in the 21st century the US
economy has been able to create jobs only in domestic
nontradable services. Independent studies by economists
at Northeastern University (reported in The Boston
Globe by Charles Stein, Feb. 20, 2005[In
the job market, some win, some lose]) and by
Edwin S. Rubenstein conclude that most of the new jobs
in domestic services have gone to new legal and illegal
immigrants. If these studies are correct, employment
growth of native-born Americans has ceased in the 21st
century.

In the 21st century, the US labor
force has been acquiring the complexion of a third world
country, with new jobs available only in domestic
services. In contrast, China and India are acquiring
high tech manufacturing and professional service jobs,
the mark of first world countries.

How does the US gain from inability
to create jobs in export and import-competitive goods
and services?

How do Americans gain from the loss
of the jobs, careers, and incomes associated with the
production of the goods and services that they consume?

How do US firms gain, beyond the
short-run advantage of CEO bonuses and share prices
based on quarterly performance, from becoming brand
names with a sales force marketing foreign made goods?

How does America as a whole gain
when the US pays for the cheap foreign labor contained
in the offshored goods and services (a major component
of the rising trade deficit) a second time by handing
over to foreigners more of its existing stock of assets?
The "cheap
Wal-Mart goods" are not cheap when properly
measured.

How do US universities gain when
there are
no payoffs to a university degree? The BLS estimates
that the vast majority of the new jobs that the economy
is expected to create during the next ten years require
no university education.

Where is patriotism when politicians turn a blind eye
to the decimation of opportunity for native-born
citizens?

What is the state of economic
education in the US when economists cannot comprehend
the reality that confronts them?